Yuan hits critical levels for FX product, could push currency lower

HONG KONG, March 20 The slide in the yuan to
near one-year lows has left it at critical levels for holders of
an offshore derivatives product, exposing them to heavy losses
that may fuel a further slide in the currency.

The yuan's 0.8 percent drop in the three days since the
central bank widened its daily trading band has rippled into the
offshore market where billions of dollars of leveraged bets were
sold to Chinese companies.

The derivatives - target-redemption forwards - offer regular
income to the holders as long as the yuan does not weaken
sharply. Deutsche Bank and Morgan Stanley estimate a total of
$350 billion of the products have been sold since last year.

Originally sold as a currency hedge, they morphed into a
product providing modest income if the yuan stayed above a
specific price against the dollar.

For many buyers of the product, it appeared a reasonable bet
because the yuan had risen against the dollar in every year
since 2010. Last year, it rose 2.9 percent against the dollar.

However, this year the central bank has engineered a fall in
the currency to shake out hot money making a one-way
appreciation bet on the currency and the decline has accelerated
since the trading band widened on Monday to 2 percent either
side of the daily fixing.

Traders said debt jitters following the country's first
domestic bond default and worries about a slowdown in the
economy are also weighing on market sentiment.

In onshore trading on Wednesday the spot rate of the
currency fell to more than 6.2 per dollar, while in the offshore
market in Hong Kong it hit 6.1855, some of the currency's lowest
levels since last April. More importantly, that is deep in the
strike zone of 6.15 to 6.20 where most of the products were sold
and where holders are exposed to losses.

"The offshore yuan may fall more as banks hedge their
structured products exposure via the derivatives market which
may exacerbate the selloff in the currency," said Geoffrey
Kendrick, head of Asia FX and rates strategy at Morgan Stanley
in Hong Kong.

Every pip the yuan stays below the strike levels, holders
are counting losses on their holdings. Five market sources
estimated losses of $3 billon had already been racked up in the
past week or so.

If holders of these products rush to unwind their positions,
it would push the yuan down further. Banks also need to hedge
their positions via the derivatives markets, and given the
asymmetrical nature of the products that could also result in
downward pressure on the yuan.

Market players say that if the offshore yuan falls to 6.20
yuan per dollar, it will trigger major requirements for holders
to make payments to their counterparties.

Morgan Stanley said it expects holders to face potential
losses of up to $200 million per month if the yuan holds below
6.20 yuan per dollar. With average maturities of the structured
products around 24 months, total losses could run into billions
of dollars.

However, the yuan would have to remain consistently below
6.2 per dollar for such heavy losses to accumulate.

While one-year offshore forwards, or non-deliverable
forwards, are suggesting the yuan will reach 6.22 per dollar in
a year, ANZ predicts the currency will be valued at 6.08 per
dollar at the end of this year.

WATCH

Derivative markets though are also signalling more yuan
weakness.

Implied volatility on one-month dollar/yuan options, a gauge
of perceived price swings, headed back towards a record on
Wednesday and double the levels seen in all of 2013. Forward
options points indicated more selling pressure.

The greater the volatility the more that banks will have to
hedge their positions by buying dollars in the cash and
derivative markets.

"Watch the vol," said the head of a currency trading desk at
a European bank in Hong Kong, who declined to be identified
because he was not authorised to speak openly to the media.

With the central bank signalling its comfort with a weaker
currency, the absence of dollar selling by companies has only
accelerated the fall in the yuan.

"They are sending a message that you don't speculate on the
yuan," said the executive director of an Asian macro hedge fund
in Hong Kong, who also declined to be identified in the absence
of authorisation to speak openly to the media.
(Editing by Neil Fullick)

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